This risk is observed when interest rate fluctuation decreases profits either by increasing financial charges or by reducing financial income. For example, if an Indian company has borrowed US dollars at the floating rate of interest and wants to renew the debt, the interest charge will increase since the new rate would normally be higher. Financial charges appearing in the income statement would increase. Similarly, another company that wants to borrow French francs after six months fears an increase in French rates; it would suffer a loss of opportunity by not borrowing now. The enterprise that issues fixed-income bonds pays interest which is not affected by changes in market conditions. If interest rates decrease subsequent to the bond issue, the issuer suffers a loss vis-à-vis its competitors. The situation is identical for an investor who has bought fixed income bonds. If the rate goes up, once the purchase has been done, the investor suffers a loss in comparison to those investors who had waited for rate increase. On the other hand, if the rates decrease, subsequent to the purchase, the investor makes a gain in his income vis-à-vis other operators who did not buy the security at the opportune moment. Interest rate risk is measured by sensitivity and duration.
Bond prices vary in opposite direction to that of interest rate variation. When two bonds differ only in terms of their interest rates, the one having the lower coupon will vary more for the same variation of market interest rate. When two bonds differ only in terms of their maturity, the one having the longer maturity will vary more for the same variation of the market interest rate. For every bond, a given increase in the interest rate results into a smaller variation of price than an identical decrease in the interest rate. For a given percentage increase or decrease of interest rate, and everything else being the same, price variation is higher for the security with the lower coupon. In general, the sensitivity of a fixed-income bond is greater if coupon rate is smaller and its residual period is longer.
Duration is an index of time during which an investor recovers his funds initially invested. The securities with longer duration have greater volatility than those of shorter duration. Thus, the higher duration implies greater risk. If the duration of the asset is higher than that of liability, the financial firm is holding a long position and then the risk comes from the increase in rates, as decrease in the value of assets held will be higher than the advantage accruing from a decrease in sum payable. On the other hand, if the establishment holds a short position, i.e., the duration of the asset is smaller than that of liability, the risk emanates from a decrease in rates. The traditional instrument used on financial market is fixed-coupon bond. This instrument has undergone several modifications to make it adaptable to the environment characterized by interest rate volatility.